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Accounting
Chapter 1
Accounting consists of three basic activities – it identifies, records, and communicates the economic events of an organization to interested users. Three activities As a starting point to the accounting process, a company identifies the economic events relevant to its business , after it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured. In monetary units. Finally, it communicates the collected information to interest users by means of accounting reports , normally called financial statements. Such data are reported in the aggregate. A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Bookkeeping involves only the recording of economic events. Who uses accounting data?
- Internal users Managers who plan, organize, and run the business. Managerial accounting provides internal reports to help users make decisions about their company.
- External users Individuals and organization outside a company who want financial information about it. Investors use accounting information to decide whether. To buy, hold, or sell ownership shares of a company. Creditors use accounting information to evaluate the risk of granting credit or lending money. External users use financial accounting. Taxing authorities, regulatory agencies, customers, labor unions. Ethics in financial reporting is fundamental. Accounting standards To ensure high-quality financial reporting, accountants present financial statements in conformity with accounting standards that are issued by standard-setting bodies. There are two primary accounting standard-setting bodies:
- International accounting standards board (IASB)
- Financial accounting standards board (FASB) The international accounting standards board determines the international financial reporting standards (IFRS). (common in EU) The financial accounting standards board determines the generally accepted accounting principles (GAAP). (common in the USA)
Measurable principles Relevance means that financial information is capable of making a difference in a decision. Faithful representation means that the numbers and descriptions match what really existed or happened. Historical cost principle, the companies must record assets at their cost. Fair value principle, states that assets and liabilities should be reported at fair value. Assumptions Monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in money terms. Economic entity assumption requires that the activities of the entity be kept separate and district from the activities of its owner and all other economic entities. Proprietorship A business owned by one person is generally a proprietorship. Only a relatively small amount of money is necessary to start in business as a proprietorship. The owner receives any profits, suffers any losses, and is personally liable for all debts of the business. Partnership A business owned by two or more people associated as partners is a partnership. There is a partnership agreement. Corporation A business organized as a separate legal entity under jurisdiction corporation law and having ownership divided into transferable share is a corporation. Shareholders enjoy limited liability; the corporation enjoys an unlimited life. The accounting equation The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. Claim of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called equity. Assets = liabilities + equity Liabilities appear before equity in the basic accounting equation because they are paid first if a business is liquidated. The accounting equation applies to all economic entities. Assets Assets are resources a business owns. The common characteristic possessed by all assets is the capacity to provide future services or benefits. Liabilities Liabilities are claims against assets – that is, existing debts and obligations.
- Account payable --> suppliers
- Note payable --> lenders
- Salaries and wages payable, sales and real estate taxes payable --> employees + government
Assets: cash + accounts receivable + suppliers + equipment Liabilities: accounts payable Equity: share capital + revenues – expenses – dividends The income statements, retained earnings statement, statement of cash flows, and comprehensive income statement are all for a period of time, whereas the statement of financial position is for a point in time.
- Income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time. The income statement reports the success or profitability of the company’s operations over a specific period of time. When revenues exceed expenses, net income results. When expenses exceed revenues, net loss results.
- Retained earnings statement summarizes the changes in retained earnings for a specific period of time. There are beginning retained earnings, net income and dividends. The information provided by this statement indicates the reasons why retained earnings increased or decreased during the period. If there is a net loss, it is deducted with dividends in the retained earnings statement.
- Statement of financial position reports the assets, liabilities and equity of a company at a specific date. Total assets must equal total equity and liabilities.
- Statement of cash flows summarizes information about the cash inflows and outflows for a specific period of time. It reports (1) the cash effects of a company’s operation during a period. (2) its investing activities (3) its financing activities (4) the net increase or. Decrease in cash during the period, (5) the cash amount at the end of the period.
- Comprehensive income statement presents other comprehensive income items that are not included in the determination of net income.
Chapter 2
The account An account is an individual accounting record of increases and decreases in a specific asset, liability, or equity item. An account consists of three parts: (1) a title, (2) a left or debit side, (3) a right or credit side. Debits and credits The term debit indicates the left side of an account, and credit indicates the right side. Dr. debit, and Cr. Credit. We use the terms debit and credit in the recording process to describe where entries are made in accounts. The act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account. An account shows a debit balance if the total of the debit amounts exceeds the credits, an account shows a credit balance if the credit amounts exceed the debits. We record the increases in cash as debits, and the decreases in cash as credits. Debits +, decreases – The double-entry accounting system is the basis of accounting systems worldwide. The equality of debits and credits provides the basis for the double-entry accounting system of recording transactions. Assets Debit for increase Credit for decrease Normal balance Dividends Debit for increase Credit for decrease Normal balance Expenses Debit for increase Credit for decrease Normal balance Debits Credits Increase assets Decrease liabilities Decrease share-capital Decrease revenues Increase expenses Decrease assets Increase liabilities Increase share-capital Increase revenues Decrease expenses Liabilities Debit for decrease Credit for increase Normal balance Share capital Debit for decrease Credit for increase Normal balance Retained Earnings Debit for decrease Credit for increase Normal balance Revenues Debit for decrease Credit for increase Normal balance Asset accounts normally show debit balances. Liabilities account normally show credit balance.
Posting The procedure of transferring journal entries to the ledger accounts is called posting. In the general journal there are all the account titles while in the general ledger there is a specialization. (a table for cash) Chart of accounts The chart of accounts is a list of the accounts and the account numbers that identify their location in the ledger. The numbering system that identifies the accounts usually starts with the statement of financial position accounts and follows with the income statement accounts. The purpose of transaction analysis is first to identify the type of account involved, and then to determine whether to make a debit or a credit to the account. Trial balance A trial balance is a list of accounts and their balances at a given time. They list accounts in the order in which they appear in the ledger. Debit balances appear in the left column and credit balances in the right one. The total of both must be equal.
- The trial balance proves the mathematics equality of debits and credits after posting.
- A trial balance may also uncover errors in journalizing and posting.
- A trial balance is useful in the preparation of financial statements. Steps for preparing a trial balance:
- List the account titles and their balances in the appropriate debit or credit column.
- Total the debit and credit columns.
- Verify the equality of the two columns. The trial balance does not prove that the company has recorded all transactions or that the ledger is correct.
Chapter 3
Adjusting the accounts Accounts divide the economic life of a business into artificial time periods. This convenient assumption is referred. To as the time period assumption. (periodicity assumption) Fiscal and calendar years Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods. An accounting time period that is one year in length is a fiscal year. If the time period starts from January 1 to December 31 it is called calendar year. Accrual – versus cash- basis accounting Under the accrual basis, companies record transactions that change a company’s financial statements in the periods in which the event occur. Normally, big company does it. Under cash-basis accounting companies record revenue at the time they receive cash. Accrual-basis accounting is therefore in accordance with International Financial Reporting Standards (IFRS). Recognizing revenues and expenses Revenue recognition principle When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company meets this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. Expense recognition principle “let the expenses follow the revenues” This practice of expense recognition is referred to as the expense recognition principle. It requires that companies recognize expenses in the period in which they make efforts to generate revenue.
Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation. The purpose of depreciation is to cost allocation. ACCOUNTING FOR PREPAID EXPENSES Example Insurance, supplies, adverting, rent, depreciation Reason for adjustment Prepaid expenses originally recorded in asset accounts have been used Accounts before adjustment Asset overstated Expenses understated Adjusting entry Debit: expenses Credit: assets
2. Unearned revenues When companies receive cash before services are performed, they record a liability by increasing a liability account called unearned revenues. A company now has a performance obligation to transfer a service to one of its customers. The adjusting entry for unearned revenues results in a decrease to a liability account and an increase to a revenue account. Without adjustment, revenues, equity and net income are understated and liabilities will be overstated. ACCOUNTING FOR UNEARNED REVENUES Example Rent, magazine subscriptions, customer deposits for future service Reason for adjustment Unearned revenues recorded in liability account are now recognized as revenue for service performed Accounts before adjustment Liabilities overstated Revenues understated Adjusting entry Debit: liabilities Credit: revenues The second category of adjusting entries is accruals. The adjusting entry for accruals will increase both a statement of financial position and an income statement account. 3. Accrued revenues Revenues for services performed but not yet recorded at the statement date are accrued revenues. An adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account. Revenue and receivable are recorded for unbilled services. Without the adjusting entry, assets and equity on the statement of financial position and revenues and net income on the income statement are understated.
ACCOUNTING FOR ACCRUED REVENUES
Example Interest, rent, services Reason for adjustment Service performed but not yet received in cash or recorded Accounts before adjustment Revenues understated Asset understated Adjusting entry Debit: assets Credit: revenues
4. Accrued expenses Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. An adjusting entry for accrued expenses results in an increase (debit) to an expense account and an increase (credit) to a liability account. Types of accrued expenses:
- Accrued interest
- Accrued salaries and wages 1. Accrued interest (1) The face value of the note (2) The interest rate, which is always expressed as an annual rate (3) The length of time the note is outstanding Without this adjusting entry, liabilities and interest expense are understated, and net income and equity are overstated. ACCOUNTING FOR ACCRUED EXPENSES Example Interest, rent, salaries Reason for adjustment Expenses have been incurred but not yet paid in cash or recorded Accounts before adjustment Expenses understated Liabilities understated Adjusting entry Debit: expenses Credit: liabilities Adjusted trial balance and financial statements The adjusted trial balance shows the balances of all accounts, including those adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.
Expense recognition principle The expense recognition principle dictates that companies recognize expense in the period in which they make efforts to generate revenue. Full disclosure principle The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statements users. Cost constraint The cost constraint weights the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.
Chapter 4
At the end of the accounting period, the company makes the accounts ready for the next period. This is called closing the books. In closing the books, the company distinguishes between temporary and permanent accounts. Temporary accounts related only to a given accounting period. They include all income statement accounts and the dividends accounts. The company closes all temporary accounts at the end of the period. Permanent accounts related to one or more future accounting periods. They consist of all statement of financial position accounts, including equity accounts. Permanent accounts are not closed from period to period. TEMPORARY These accounts are closed All revenue accounts All expense accounts Dividends
PERMANENT
These accounts are not closed All asset accounts All liability accounts Equity Preparing closing entries Closing entries formally recognize in the ledger the transfer of net income and dividends to retained earnings. Closing entries also produce a zero balance in each temporary account. Income summary transfers the resulting net income or net loss from this account to retained earnings.
- Current assets Assets that a company expects to concert to cash or use up within one year or its operating cycle. Account receivable, supplies, cash, investments, receivables, inventories, and prepaid expenses.
- Equity Equity for corporations are share capital-ordinary and retained earnings. Retained earnings: income summary + dividends
- Non-current liabilities Obligations that a company expects to pay after one year. Bond payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities
- Current liabilities Obligations that the company is to pay within the coming year or its operating cycle Accounts payable, salaries and wages payable, notes payable, interest payable, income taxes payable
